Managing the load

By Eric Lascelles

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RBC Global Asset Management’s chief economist tells us why the world’s debt hot spots do not appear to be facing an imminent crisis, and how investors should think about global debt risk going forward.

Q. As interest rates are being normalized, are there any debt threats that could surface in the near or medium term?

A. We are budgeting for a palpable increase in interest rates, and this does increase the vulnerability of all debt.

There are problematic debt situations in the world, but they’re mostly manageable. Think of Venezuela which is likely to officially restructure/default on its $89B of debt. While a large amount, it’s not world-altering and should be of limited consequence for global debt markets given that it has been widely expected.

Housing bubbles in the world and some of the leveraging that’s happened in certain household sectors are more worrying, including in Canada and Australia.

Canadian housing share of GDP

Sources: Haver Analytics, RBC Global Asset Management

Beyond this, there is Chinese debt risk and Southern European banks are still vulnerable, with high non-performing loans in Greece, Italy, and Cyprus.

In addition to these hot spots, we must recognize more generally, that with the global economy healthy, leverage is rising in many places, and investors are taking more risk as they seek additional return. Inevitably there will be some nooks and crannies that grow larger than they should, such as volatility funds or high-yield debt. One can easily imagine some pain coming eventually from one of these.

Q. Chinese debt risk seems to have diminished. Is the country moving in the right direction?

A. Chinese debt is the biggest credit risk, with potentially global consequences. Fortunately, the associated risks have shrunk to some extent recently, and are thus less likely to manifest themselves in the near term.

The good news on Chinese debt is two-fold. One is the country’s recent pivot toward focusing on the quality of economic growth rather than simply targeting high economic growth. In so doing, Chinese authorities aim to be less reliant on credit which would very much reduce the risks going forward. In fact, Chinese credit growth is already slowing quite considerably. We’ll see if that sticks.

Less appreciated are the bad loans on Chinese banks’ books. The loans aren’t housing-related as widely thought, but are linked to heavy industries like steel and cement—mainly state-owned enterprises. Happily, these industries have begun significant consolidation efforts, prodded by a government effort to reduce excess capacity. As a result, bad loans seem to be shrinking quite quickly.

Chinese total social financing, or credit growthYear-over-year % change

And so, the potential trigger for a Chinese debt crisis has faded in the near term, but I would still say China deserves a place of prominence in any list of medium-term debt risks given the magnitude of corporate debt and how quickly it has accumulated.

Restrained credit growth is one of several reasons why we expect the Chinese economy to slow over the next few years.

Q. Given U.S. federal debt-to-GDP is forecast by the Congressional Budget Office to surge to 150% over the next 30 years from 77% currently, is the U.S. vulnerable?

A. I’m not convinced that the U.S. is going to encounter a debt crisis. A 150% debt-to-GDP ratio is not necessarily unsustainable, at least for the U.S.

At the very start of the financial crisis, prominent academic research stated that a 90% government debt-to-GDP ratio was a threshold. And beyond that level, economic growth would suffer materially. It’s not clear that’s true. In fact, the International Monetary Fund did some subsequent work and argued that there was no obvious threshold—it is more likely that the causality is reversed: slow growth translates into high debt.

Even if debt-to-GDP does rise to 150%, I suspect the U.S. will still be able to borrow at a relatively low rate since the U.S. debt market and the U.S. financial markets more generally are the deepest and most liquid in the world. Moreover, the U.S. dollar is the world’s main reserve currency. As such, if any country can handle a whole lot of debt and still attract the necessary capital, it would be the U.S. I would not blink an eye if in 50 or 70 years the U.S. debt-to-GDP is sitting at 230%, just like Japan, with a similarly low interest rate.

It’s hard for me to envision the bond market complaining much about U.S. sovereign debt over the next decade. So as much as I would love for the U.S. debt profile to be on a more sustainable track, I don’t look for this to be an essential issue.

Q. How should investors think about debt crisis risk in their portfolio if there is no real imminent debt crisis foreseeable at the moment?

A. I think it’s more about recognizing that debt is one of several threats to the broader economic landscape that might at some point undermine economic growth and have a broad impact on financial markets as a whole.

These potential debt hot spots are not guaranteed to blow up. They are mainly just things that will be lingering in our mind over the next five to 50 years, and cause us to be slightly less risk-seeking than otherwise in our investments, but hardly cowering in the corner either.

Two factors are worth watching. One will be the business cycle. We believe this expansion could end in more conventional ways, with the economy overheating, such as it did in the U.S. in the early ‘90s, as opposed to the last couple of go-arounds when there was a full-on bubble or debt crisis that took the economy down.

And so we are also watching for evidence of rising leverage and debt levels, not because it’s likely to create a full-on debt crisis, but because it can be a contributing factor to a cooler economy later.

Non-U.S. Analyst Disclosure: Eric Lascelles, an employee of RBC Wealth Management USA’s foreign affiliate RBC Global Asset Management Inc.; contributed to the preparation of this publication. This individual is not registered with or qualified as research analysts with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated person of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.

The article is for information only and contents do not constitute recommendation to purchase any investment product. Nothing in this article constitutes legal, accounting or tax advice and you are advised to seek independent legal, tax and accounting advice prior to acting upon anything contained in this article.

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